EU Stress Tests Fail to Reassure Investors Wary of Criteria

July 24 (Bloomberg) -- European regulators found that seven banks need to raise a combined 3.5 billion euros ($4.5 billion) of capital, underwhelming analysts who said the stress tests may not have been strict enough.

âThe amount of capital needed is much lower than the market expected,â said Mike Lenhoff, chief strategist at London-based Brewin Dolphin Securities Ltd., which oversees $33 billion. âIt seems quite trivial considering the concerns about losses from the sovereign crisis.â

Germanyâs Hypo Real Estate Holding AG, Agricultural Bank of Greece SA and five Spanish savings banks didnât have adequate reserves to maintain a Tier 1 capital ratio of at least 6 percent in the event of a recession and sovereign-debt crisis, lenders and regulators said yesterday. The banks that failed the stress tests are in âclose contactâ with national authorities over how they will raise capital, said the Committee of European Banking Supervisors, which ran the assessments of 91 lenders.

European governments are using their first coordinated stress tests to reassure investors about the health of financial institutions after the debt crisis pummeled the bonds of Greece, Spain and Portugal. Rising budget deficits in those countries raised concern that they wonât be able to pay their debts.

âThis is not reassuring at all,â said Komal Sri-Kumar, who helps manage $118 billion as chief global strategist at TCW Group Inc. in Los Angeles. âThese tests were set in such a way that most of them would pass. That doesnât say to me that the banking system is stable.â

âNot Very Rigorousâ

Before the results were published yesterday, analysts at Goldman Sachs Group Inc. estimated that lenders would need to raise 38 billion euros and Barclays Capital said they would require as much as 85 billion euros. Tests carried out in the U.S. last year found that 10 lenders, including Bank of America Corp. and Citigroup Inc., needed $74.6 billion.

âI donât think the market is so stupid as to think that they were so wrong,â said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, New Mexico, which oversees about $57 billion. âThe right explanation here is that the testing was not very rigorous.â

European banks have already raised 220 billion euros in the past 18 months, Credit Suisse Group AG analysts said in a report this week. With that amount already raised, it was likely that most European banks would pass the tests, the analysts said.

Trading Books

Analysts and investors said the European tests may not have been strict enough because they ignored the majority of banksâ holdings of sovereign debt. The evaluations took into account potential losses only on government bonds the banks trade, rather than those they are holding until maturity, CEBS said.

Lenders hold about 90 percent of their Greek government bonds in their banking book and 10 percent in their trading book, according to a survey by Morgan Stanley analysts led by Huw van Steenis. They have to write down the value of bonds in their banking book only if there is serious doubt about a stateâs ability to repay in full or make interest payments.

âThe long-awaited stress tests do not seem to have been that stressful,â Gary Jenkins, an analyst at Evolution Securities Ltd. in London, wrote in a note to clients. âThe majority of these bonds are held on the banking books.â

The European Central Bank said banks that failed the stress tests should seek to raise capital from investors before turning to national governments. Spain and Greece both moved to support their lenders that require capital.

Greek Rights Offering

âThe ECB welcomes the commitment made by national authorities with regard to back-stop facilities to recapitalize the institutions that may have fallen below the minimum threshold of 6 percent,â the ECB said in a statement.

Agricultural Bank of Greece, the only one of the nationâs lenders to flunk, said itâs preparing a rights offering after posting a shortfall of 242.6 million euros. The government, which owns 77 percent of the bank, said it will take part in the share sale.

Hypo Real Estate, the German commercial-property lender rescued by the government during the financial crisis, had a capital shortfall of about 1.25 billion euros. An âimmediate need for capital would arise only if the hypothetical stress scenario actually did materialize,â the Bundesbank and financial regulator BaFin said.

Spanish savings banks CajaSur; a group led by Caixa Catalunya; a group led by Caixa Sabadell; Caja Duero-Caja Espana; and Banca Civica all, posting a combined capital shortfall of 2 billion euros.

Stocks Little Changed

Bank of Spain Governor Miguel Angel Fernandez Ordonez said the central bank will set a deadline for the banks to raise capital privately before turning to public funds. Civica said yesterday it would raise 450 million euros by selling a convertible bond to U.S. leveraged buyout firm J.C. Flowers & Co.

âThe seven that failed the tests were already banks that had failed or were in the watch list, and that says to me that these tests are not telling us anything we donât already know,â Sri-Kumar said. âI donât think the markets will buy it. Weâll have to wait until the Europe markets open on Monday.â

Ay, ay, ay. So many self-proclaimed "experts" out there claiming the invalidity of stress test criteria. I think we need another 20 % stock indices rally. May I recall that 70 % of mutual and bond fund managers are expecting a Greek default ?